Tuesday, April 20, 2010

Arthur Pigou and the Invisible Hand

Thom Lambert writes (19 April) in the Truth on the Market Blog http://www.truthonthemarket.com/2010/04/19/some-warnings-for-modern-pigovians-from-pigou-himself/:

“Some Warnings for Modern Pigovians (from Pigou Himself)”

“These various interventions to correct for externalities are the brainchild of Cambridge economist Arthur Cecil Pigou. Writing in the 1920s, Pigou recognized that negative externalities would result in “too much” of an activity and that positive externalities would result in “too little.” He thus concluded that when externalities exist “[n]o ‘invisible hand’ can be relied on to produce a good arrangement of the whole from a combination of separate treatments of the parts. It is therefore necessary that an authority of wider reach should intervene.”

Specifically, he asserted, [i]t is … possible for the State, if it so chooses, to remove the divergence in any field by ‘extraordinary encouragements’ or ‘extraordinary restraints’ upon investments in that field. The most obvious forms which these encouragements and restraints may assume are, of course, those of bounties and taxes.

In other words, the government should tax activities that create negative externalities and subsidize those that create positive externalities, thereby ensuring that the actors at issue bear the full costs and benefits of their conduct. If they do, they’ll act optimally, taking all actions that create benefits in excess of cost and none that don’t. Thus was born the idea of “Pigovian” taxes and subsidies — the notion underlying the proposed climate change legislation, President Obama’s bank tax, the various subsidies for electric vehicles, and scads of other government interventions into private affairs.”

Comment
This is a relevant point by Arthur Cecil Pigou (1877-1959), author of The Economics of Welfare, 1920 because it illustrates what his generation of economists were thinking of the phrase, the invisible hand, in those decade before Keynes’ General Theory. Pigou developed an economic rationale for welfare intervention in the externalities evident in a complex capitalist economy, and it sparked a massive interest in what became known as welfare economics that peaked in the post-war years up the 1960s (Kaldor, Hicks, Coase) and led to several spin-offs, including public choice theory. (‘Welfare economics’ was not just about social welfare re-distributive policies of modern states.)

The sentence: ‘“[n]o ‘invisible hand’ can be relied on to produce a good arrangement of the whole from a combination of separate treatments of the parts’ recognizes a conventional and mistaken treatment of the ‘invisible hand’, later popularized by such as Paul Samuelson, and comments on its practical validity.

This created the divergence between those of saw the need for a theory justifying intervention and those who preferred to rely on markets to act out what they claimed for them, using the ‘invisible hand’ as the ‘miraculous’ power of markets to create the ‘best of all possible worlds’.